China ETFs Sinking, But Don't Count Them Out

The Chinese stock market may be in full correction mode, but ongoing asset flows into the biggest ETF focused on China, the iShares China Large-Cap ETF (FXI | B-44), could be a sign that investors are still buying in to the idea that there’s an arbitrage opportunity to be had between Chinese equities listed in Hong Kong and mainland stocks.

Stocks listed in Hong Kong—so-called H-shares—have had a good run in 2015. FXI, which invests primarily in H-shares, is up about 12 percent year-to-date. That’s even after the most recent decline. But the gains aren’t nearly as noteworthy as the rally seen in the A-shares market that includes mainland China companies whose shares are listed in Shanghai or Shenzhen.

Consider that A-shares focused Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) is up 30 percent in the same period—after the latest pullback. As a whole, those A-shares market returns of 30 percent are 2.5 times as much as those of the MSCI China index covering the H-Shares market.

That means that, for now, funds like ASHR have farther to fall than do other China-focused stocks, as the chart below clearly shows. In other words, FXI hasn’t been as exciting as ASHR, but it is certainly 

Chart courtesy of StockCharts.com

Feeling The Pinch

Right now, stocks of all kinds in China are feeling the pinch of a technical sell-off, and A-shares have been hit the hardest. That’s partly because supply of stocks following a wave of IPOs has drowned out demand, and the A-shares market is largely dominated by mom-and pop-type investors who are more easily spooked than large institutions.

But even as stocks slip, investors have poured nearly $500 million in fresh net assets into FXI in June alone. That strong demand, which puts year-to-date inflows into the fund at $1.5 billion, speaks to expectations that H-shares have some catching up to do to regarding mainland stocks.

Chasing That Spread

While investors appear to be quite keen on FXI right now, they have no compunction about bailing out on ASHR. That A-shares fund has seen net redemptions of more than $280 million in June. People like Brendan Ahern, whose firm—KraneShares—offers a roster of China-focused ETFs, is quick to point out that betting on that spread might be shortsighted.

“This is more hope than arbitrage,” he told ETF.com. “The last time A-shares hit a premium over H-shares was in 2006, and they went on to hold onto that premium for four years. That premium can last a long time.”

Ahern isn’t alone. Brad Jensen of Accuvest Global Advisors told ETF.com that if anything, the recent dip—particularly in A-shares—is a buying opportunity, because the A-shares outperformance could continue. But he also notes the potential for H-shares to rally is real, and compelling.

The Case For H-Shares

“The powerful medium-term momentum in China is supported by a very attractive blend of strong growth fundamentals, relatively low valuations and accommodative government policy,” Jensen said. “We see additional upside in Chinese equities, and suggest taking advantage of the current short-term oversold conditions in the MSCI China Index.”

“However, from a risk/return perspective, the MSCI China Index has less downside risk given the index’s low valuations,” he said. “In our view, the MSCI China Index (H-shares) is compelling relative to both A-shares and U.S. equities.”

The reality is that investors are hard-pressed to find anyone who will say it’s time to abandon ship when it comes to owning Chinese equities of any kind. Quite the contrary. To Jensen, the reform-minded Chinese government will do whatever it takes to “defend growth and protect against a significant credit event,” including additional easing policies and clearer market-related regulations. That, in itself, can matter more at the end of the day to investors than quantitative data.

Plenty To Like

“Given retail’s enthusiasm for leverage, froth is definitely in the market,” Tyler Mordy of Hahn Investment Stewards told ETF.com. “And at some point, continued rapid growth in margin financing could begin to pose a systemic risk to China’s financial system. But the bullish case is simple: There are strong reasons why Beijing needs an ongoing bull market.”

Among them, he noted:

• To help create a sustainable equity capital market as an alternative to China’s dominant debt-financing channel.
• To reward elite constituencies, reassuring them there are still ways to make money in Xi Jinping’s China with its endless corruption crackdown.
• To create a “wealth effect” in China’s slowing economy.

“Beijing is pursuing sweeping economic reforms with the intent of establishing a greater role for market forces and less direct management of the economy by organs of the state,” Mordy said. “To smooth the process, a stock market boom is crucial—both to enable the further privatization of state-owned enterprises and to encourage private investment.”

“The golden rule of China investing is to monitor what the central government want. And what it wants now is a healthier market with greater liquidity and depth,” he added.